U.S. House Holds Hearing on the IRS’s Auditing of Small Businesses

IRS says it hasn’t been singling out certain small businesses for audits.

Deputy Commissioner Werfel discussed the efforts the IRS is making to help small business owners, such as the Fresh Start Initiative. According to the IRS, the Initiative “makes it easier for individual and small business taxpayers to pay back taxes and avoid tax liens.”

On July 17, the House Committee on Small Business hosted a hearing, “The Internal Revenue Service and Small Businesses: Ensuring Fair Treatment.” Daniel Werfel, IRS principal deputy commissioner, spoke before the Committee.

Committee chair Sam Graves noted in his opening statement that the IRS has increased the number of small businesses it audits. So, the purpose of the hearing was to find out more about how the IRS selects small business taxpayers for closer review and audit, the number of small businesses it audits, and the cost and results of its examinations.

Understanding the IRS’ actions is key for small businesses selected for audits. The IRS’ own statistics show that the percentage of tax returns selected for examination from corporations with assets of less than $10 million jumped from 0.63 percent in 2002 to 1.12 percent in 2011 – an increase of 77 percent in a decade. According to Werfel, audits of small businesses, including S corporations and partnerships, accounted for 21 percent of the 1.65 million returns the IRS audited for fiscal year 2012.

Also according to Werfel’s testimony, the average additional tax recommended in 2012 as a result of each small business audit was nearly $29,000. The number for self-employed individuals was almost $12,000. For most small businesses or self-employed taxpayers, these are sizable sums of money.

In his testimony, Werfel talked – albeit at a high level – of the tactics the IRS uses to determine which tax returns to examine. “As returns are processed, a majority of them are scored by a computer program for compliance risk, with a higher score indicating a higher probability that a change will be recommended during an examination.” Werfel also noted that while the computer score is the most frequent reason for choosing a return for examination, one also may be selected if, for instance, the IRS needs to reconcile the information on the return with third-party information provided on W-2s, 1099s or other forms.

A return also may be chosen for an audit through the IRS’ National Research Program. The Program is intended to help the IRS improve its criteria for audit selections.

Werfel discussed the efforts the IRS is making to help small business owners, such as the Fresh Start Initiative. According to the IRS, the Initiative “makes it easier for individual and small business taxpayers to pay back taxes and avoid tax liens.”

For instance, the Fresh Start Streamlined Installment Agreement program enables taxpayers to make monthly payments if they can’t pay their tax debt immediately. Under Fresh Start Initiative, the maximum dollar amount a taxpayer can owe and still qualify for a streamlined installment agreement rose from $25,000 to $50,000, and the maximum repayment term was increased from 60 to 72 months.

Another aid to small business owners is the simplified, optional home office deduction, Werfel noted. Rather than calculate expenses, such as utilities, related to a home office, taxpayers simply can deduct $5 per square foot for up to 300 square feet of office space. The IRS estimates the change will save 1.6 million hours of tax prep time annually.

At the hearing, Werfel addressed the perception that the IRS inappropriately targeted small businesses, according to this report in The Hill. “What I’m suggesting is that we don’t have any particular evidence at this time that the objective and analytical criteria that we put in place to review small businesses for potential increased scrutiny has any fundamental flaw that would lead one to the conclusion that there’s unfair targeting.”